U.S. economists fear 'stagflation' coming

Term means inflation rages as economy slows - something not seen in 30 years

Jeannine Aversa, Associated Press

Published
4:00 am PST, Wednesday, February 27, 2008

It's a toxic economic mix the nation hasn't seen in three decades: Prices are rising at the fastest pace in a quarter century, even as the economy loses steam.

Economists call the disease "stagflation," and they're worried it might be coming back.

Already, paychecks aren't stretching as far, and jobs are harder to find, threatening to set off a vicious cycle that could make things even worse.

The economy nearly stalled in the final three months of last year and probably is barely growing or even shrinking now. That's the stagnation part of the ailment. Typically, that slowdown should slow inflation as well - the second part of the diagnosis - but prices are still marching higher.

The latest worrisome news came Tuesday: a government report showing wholesale prices climbed 7.4 percent in the past year, the biggest annual leap since 1981.

"We're in a slowdown," press secretary Dana Perino said at the White House, where the economics talk was still upbeat until recently.

Once the twin evils of stagflation take hold, it can be hard to break the grip. People cut their spending as they are stung by rising prices and shriveling wages. Businesses, also socked by rising costs and declining demand, clamp down on their hiring and capital investment.

That would be a nightmare for Wall Street investors, businesses, politicians and most everyone else. They're already looking to the Federal Reserve for help, but the Fed's job is complicated by the situation.

The mission of Federal Reserve Chairman Ben Bernanke and his colleagues is to nurture economic growth and keep inflation under control. To brace the teetering economy, the Fed since September has been cutting its key interest rate. Another cut is expected in March. However, to combat inflation, the Fed would be expected to boost rates instead.

"The Fed has its hands full. It is preoccupied with the economic slowdown at the front door, but inflation looks to be sneaking in the back door," said Greg McBride, senior financial analyst at Bankrate.com. "If that trend continues, the Fed would need to show the economy some tough love, meaning higher interest rates to keep inflation from getting out of hand."

On the other hand, Brian Bethune, economist at Global Insight, said Bernanke can fight only one war at a time, and the more pressing issue right now is to shore up the ailing economy. "That's the war that needs to be fought. The war on inflation will have to come another day," Bethune said.

Maybe things won't be so bad. Stock prices rose for the day, continuing a recent rally. The Dow Jones industrials closed up 114.70 points. And Federal Reserve Vice Chairman Donald Kohn said in a speech that he doesn't expect the recent elevated inflation readings to persist.

"But the recent information on prices underlines the need to continue to monitor the inflation situation very carefully," he said.

Some numbers underscore the concerns:

-- Consumer prices were up 4.1 percent last year, the biggest increase in 17 years. Those higher prices - especially for heating homes and filling up gas tanks - are taking an ever-bigger bite out of paychecks. Workers' weekly earnings are down 1.4 percent from January a year ago when adjusted for inflation.

-- Oil prices galloped past $100 a barrel to close at a record $100.88 Tuesday. Those lofty energy prices are a double-edged sword: They can spread inflation through the economy by boosting the prices of lots of other goods and services, and they can leave people with less money to spend on other things, thus slowing overall economic activity.

People are hunkering down. Earlier this month, nervous shoppers handed the nation's retailers their worst January in almost four decades. High gas and food prices, the toll of the housing bust, the credit crunch and a tougher job market all were to blame.

Wary employers eliminated jobs in January, the first nationwide loss of jobs in more than four years.

With the economy on the edge of a recession - if it hasn't toppled over already - the Fed for the near term is much more likely to keep lowering rates. Yet, with its own forecast revised last week to show even slower growth this year as well as higher inflation and higher unemployment than previously anticipated, Bernanke and his colleagues have made clear they'll need to stay nimble.

Can a serious bout of stagflation be avoided? Many economists believe the Fed's aggressive rate cuts along with tax rebates for people and tax breaks for businesses will lift the economy in the second half of the year.

Until then, analysts warn that it could feel like the country is suffering through a mild case of stagflation- even if technically that is not the case.

In the past stagflation episode in the 1970s and early 1980s, inflation sometimes hit double digits - much higher than the current rate. And unemployment was higher, too. In 1975, for instance, the jobless rate zoomed to 8.5 percent, which at the time was the highest since the early 1940s. Last year, by contrast, the jobless rate averaged 4.6 percent.

"In the real economy, activity looks slow but not disastrous," Alice Rivlin, former vice chair of the Federal Reserve, told Congress Tuesday. But she added: "Uncertainty remains great. ... The risks are mainly on the downside, and gloomier forecasts are not hard to find."